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Opalesque Islamic Finance Intelligence

Allocator Interview: Gold Bullion and Islamic Private Equity: Protection and Production, Shahzad Siddiqui & Toby Birch

Thursday, September 02, 2010

Shahzad Siddiqui is a Toronto-based lawyer and Chief Legal Officer at Broadwater Capital Inc, a Toronto-based Islamic finance firm. He was previously an investment banker at Ittihad Securities, an Islamic private equity firm in the same city. He is an author of several Euromoney publications including Sovereign Sukuk, co-written with a manager at the Ontario Financing Authority, and Fruits of the Orchard: Endowments for Mosques and Islamic Charitable Organisations in Western and Muslim Lands.

Toby Birch is Managing Director of Oppenheim and Co Limited (investment management) and Guernsey Gold Limited (bullion dealing). He is a Chartered Fellow of the Chartered Institute for Securities and Investment and also hold's the Institute's Islamic Finance Qualification. He is author of The Final Crash, one of the most prescient predictions of the credit crisis published in May 2007. He was previously CEO at Blackfish Capital Holdings where he managed a resources-based hedge fund and senior investment manager at Bank Julius Baer in Guernsey.

I. Redux: how Private Equity is aligned with Islamic Philosophy

Writing in the Financial Times, Nassim Taleb, author of The Black Swan, highlighted the robustness of equity compared with the destabilizing effect of debt. [i] While equity volatility is transparent and immediate, debt-based risks are not, except when in default. Ideally, banks should evolve from accumulating hidden risks to acting as agents of economic activity. This is exactly what Islamic financial theory promotes. Equity is the purest way to share risk and reward either by way of private equity for more mature and specialist projects or venture capital for start-ups. As noted in chapter 2, on the history of private equity, Silicon Valley has been the hotbed for funding some of the most successful companies in American corporate history using venture cap methods.

However, events in America have also proceeded in the opposite direction, with the formation of the Federal Reserve in 1913. The rationale behind the Reserve was to provide 'elasticity' for the money supply. In the nine decades that followed, there was a 96% decline in the purchasing power of the dollar.

This had an effect on the sphere of private equity, where we witnessed a mutation of the original spirit of risk-sharing via share options, massive debt and a tax system biased towards use of leverage. Prior to the crisis, private equity became a by-word for highly aggressive acquisitions. Companies that tried to be conservative in the run-up to the crisis became take-over targets, such that greater leverage was either the default defensive position or was saddled onto them post-buyout. Like a good marriage, risk and reward are the yin and yang of markets where the excess of each component is mutually tempered by the other.

However, this symbiotic process has been increasingly disentangled in recent years, with resulting economic chaos. This has important implications for private equity, bullion and other financial instruments. In the public sector, there is a focus on quota-based systems where meeting annual targets very often overrides quality of service to the end-user. This focus on targets rather than quality can also take place within corporations. The corporate role is to offer products or services that are competitive and provide value for money. As the corporation achieves volume and market share, customers benefit and shareholders enjoy dividends and potential stock appreciation. When shareholder, staff and customer interests are aligned, a winning formula is achieved. Indeed, some investment houses specifically target companies where employees hold significant equity, because they offer a competitive advantage for long-term investors. However, good ideas can be mutated by short-term thinking. Through this mutation, the healthy approach of sharing risk and reward through public equity has become deformed through leverage and derivatives.

Stock price targets are used as an incentive to align management with shareholders but can have unintended consequences. In trying to meet quarterly (and therefore, short-term) price targets, corporations may start "cutting corners" on their product and service offering while paring costs and benefits to non-managerial staff. They may also, like Enron and Worldcom, start to manipulate earnings by spinning off loss-making components into special purpose vehicles.

Stock options can also become problematic. For example, at the peak of the Internet bubble some 80% of executive rewards stemmed from stock options. This has an effect on stewardship and long-term planning, as management and staff members with options start focusing more on shoring up the short-term value of the stock price rather than the long-term vision of the corporation. Moreover, as identified in chapter 7, on due diligence, stock dilution is a danger to the equity investor. Shareholders have lost value as earnings became diluted through the exercise of stock options. In the realm of the public markets, we have seen stock market follies of this sort, compounded by the crisis, contributing to a double-digit decline in indices like the S&P 500 from 2000-2009.

Meanwhile, the elasticity of money supply has contributed to erosion of earnings. For example, Societe Generale[ii] has analysed the inflation-adjusted earnings of American workers since 1970. They found that the top 20% of workers enjoyed a rise of 60% whereas the remaining population (4/5ths) suffered a decline of 10% since 1970. This is the true measure of purchasing power disparity through the mass-creation of money. Money creation draws wealth from the poorest to the wealthiest and has produced the so-called 'hourglass economy' [iii] that has impoverished the middle class. Private equity can act as a bulwark to the creation of an hourglass economy if it rediscovers its original and valuable purpose on a global scale. Before looking at its beneficial combination with bullion we must first understand the role of precious metals in both Islamic and Western culture.

II. Gold and Silver in Islamic Culture

The best-known coinage in Islamic history is that of the gold dinar and silver dirham. Muslims first used gold and silver by weight, but in the year 75 (695 CE) the first dirham was minted. This was followed by minting of the dinar, which continued to be the official Islamic currency until the end of the Ottoman Empire in 1924. It was later re-launched by the Islamic Mint in Malaysia in November 2001, albeit with limited success. There are many examples in the Qur'an of how gold and silver should be used in aspects of trade. In order to gain an insight into the Islamic approach to these precious commodities, it is necessary to examine some of the relevant verses.

The first mention of both gold and silver is in sura Imran, wherein it states[iv]:

Alluring to man is the enjoyment of worldly desires through women, and children, and heaped-up treasures of gold and silver, and horses of high mark, and cattle, and lands. All this may be enjoyed in the life of this world - but the most beauteous of all goals is with God.

And among the followers of earlier revelation there is many a one who, if thou entrust him with a treasure, will restore it to thee; and there is among them many a one who, if thou entrust him with a tiny gold coin, will not restore it to thee unless thou keep standing over him...

In sura Tauba (the Repentance), in keeping with the message of the entire chapter, it states: for all who lay up treasures of gold and silver and do not spend them for the sake of God - give them the tiding of grievous suffering.[v]

In sura Kahf (the Cave), there is the first description of paradise mentioning gold:

...theirs shall be gardens of perpetual bliss - through which running waters flow - wherein they will be adorned with bracelets of gold and will wear green garments of silk and brocade, wherein upon couches they will recline: how excellent a recompense, and how goodly a place to rest![vi]

Similarly, in sura Al-Hajj (The Pilgrimage), it states:

Behold, God will admit those who attain to faith and do righteous deeds into gardens through which running waters flow, wherein they will be adorned with bracelets of gold and pearls, and where silk will be their raiment.[vii]

In a continuation of this theme, in sura Al-Fatir (The Originator of Creation), it states:

Gardens of perpetual bliss will they enter, therein to be adorned with bracelets of gold and pearls, and therein to be clad in raiments of silk.[viii]

There is even a sura of the sacred book entitled Az-Zukhruf: Ornaments of Gold. This sura provides detailed arguments using gold and silver metaphors:

We might indeed have provided for those who deny the Most Gracious roofs of silver for their houses, and stairways whereon to ascend, and doors for their houses, and couches whereon to recline, and gold. Yet all this would have been nothing but...enjoyment of life in this world - whereas the life to come awaits the God-conscious with thy Sustainer.[ix]

Finally, it says of those of who believe in the Divine:

They will be waited upon with trays and goblets of gold; and there will be found all that the souls might desire, and the eyes might delight in. And therein shall you abide.[x]

Three themes emerge from these verses: (1) there will be an abundance of gold in paradise (together with pearls and silk) in the form of goblets, trays and bracelets; (2) one should not hoard gold and silver in this life; (3) gold is explicitly recognised as valuable currency.

III. A Brief History of Gold from an Islamic Perspective

In the time of Prophet Mohammed (صلى الله عليه وسلم‎), gold and silver were simply forms of currency for the purpose of buying and selling goods.[xi] Their universal value ensured that there was no need for a foreign exchange market which, in modern times, has became a boon for speculators and a burden for manufacturers. The Prophet (صلى الله عليه وسلم‎) taught that money should not be used to make money without some form of risk, otherwise the activity is a form of usury or riba. The Arabic translation is 'increase' which is sublime in its simplicity. The intention is to avoid the creation of something from nothing and was stipulated in the Qur'anic verse "...they say 'Trade is like riba, but Allah hath permitted trade and forbidden riba."[xii] The prohibition ensures that business activities are anchored in reality, whereby the sharing of risk and reward delivers a genuine economic outcome. Without this restraint, the increase of money without work becomes highly destructive.

As mentioned in chapter 3, on global and Shari'a regulation of private equity, the words of the wise have echoed down the ages to warn against usury, from Aquinas to Aristotle to the Old and New Testament. This warning about riba applies to many forms of finance, as interest-based banking is easily susceptible to speculation and the inflationary effect of credit creation. This was also well understood by the Founding Fathers of America, who insisted on gold and silver coinage when they completed the U.S. Constitution in 1789; the same year as the French Revolution. France, at that time, had racked up massive debt in supporting a foreign war. This resulted in domestic poverty, escalating food prices, growing disparity between social classes and ultimately, a violent revolution.

When gold and silver were mainstream currencies, money could not be mass-produced. This led to greater price stability over the course of centuries. Indeed, gold's purchasing power for equivalent tangible goods is little changed since the Middle Ages. However, there have been times when its restrictive effect could cause great poverty. Loans that were readily granted in wartime tended to be rapidly recalled in a post-conflict environment as financial discipline returned. This occurred after both the Napoleonic and First World Wars. Likewise, the gold price has experienced its own peaks and troughs thanks to supply shocks that distorted the market. These included several major discoveries, starting with the Spanish in the New World in the sixteenth century, Russia in the eighteenth and in North America in the nineteenth.

Since the end of the Gold Standard in the 1970s, the money supply has been increasing at an annual double digit rate, up until the credit crisis. The consequence has been a silent dilution and steady devaluation of the dollar coupled with a surge in household and government debt. This will leave generations to come with asset price inflation and liabilities that can scarcely be repaid. Most economists, however, continue to view the economy myopically as a one-sided balance sheet -looking only at the assets while ignoring the mounting liabilities.

There are many examples of how debt compounds over time due to interest and financiers are well aware of the power of compounding. Indeed, in an instructive example, we can look at a theoretical case where a person deposits 10 kilos of gold in a bank account and receives 3% compound interest back in gold. If they did not withdraw the gold from the account, the bank would have to pay back the depositor's heirs all the gold that has been mined by approximately year 484.[xiii] According to precious metal consultants GFMS the total above-ground estimate for stocks of gold stand at 163,000 tonnes, as at the end of 2008.

However, many continue to believe that the growth in debt is benign and cling to the Keynesian principle that it can be paid back in better times. History shows us that this is rarely the case and, in spite of the purported growth of the last decade, developed countries carry debts that can never realistically get repaid. By way of example, the total net liabilities of Britain and Germany stand at 400% GDP with the USA and France at 500%.[xiv]

While it is acceptable in Islam to hold gold and silver bullion for wealth preservation, the Shari'a-sensitive investor has to be mindful of the injunctions against hoarding. This approach applies as much to food and knowledge as it does to wealth. Commodities like gold and silver are gifts or trusts (amanah) from God and are meant to be shared and circulated. To prevent the purchase of gold becoming a form of hoarding, it is essential that any bullion stored or possessed by a Muslim be included as part of their annual zakat calculation for charitable donations. This forces the investor to do something useful with their possessions. If not, their wealth will gradually flow toward charitable purposes, giving stagnant money a half-life. Rather than allowing wealth to fester, zakat helps draw it out of dark storage into the light of economic purpose; a case of'use it or lose it.' The investor can still benefit and be rewarded but the process ensures that liquidity is provided communally, thereby giving others the chance to create their own wealth and prosperity. This is a true trickle-down effect in direct contrast to interest-based banking that concentrates wealth rather than spreading it.

IV. Gold in the Modern Era

Gold has captured the public imagination in times both ancient and modern. One only has to think of movies like King Solomon's Mines or Goldfinger, with its depiction of bullion bars held at Fort Knox. Gold's enduring nature, verifiable purity and portability has made it an ideal store of wealth throughout history. Its malleability, ductility and consistent quality allow for easy division and use as coinage. Gold has stood the test of time as a keeper of value throughout, subject to cyclical peaks and troughs.[xv] The classic correlation of a weakening dollar and stronger gold price reared back to life, especially during the credit crisis, such that gold and related mining shares have proven to be the best performing asset class of the last decade. Gold gained some 280% in the ten years from 2000-09 while mainstream equities delivered negative returns, even with dividends re-invested.

In the four decades since the Gold Standard was abandoned, central banks have been free to control their economies through monetary policy, uninhibited by the constraints of holding real assets to back paper currency. Central banks sometimes dismiss the rise in bullion as it is seen as a'vote of no confidence' in paper money and, hence, a poor reflection of their stewardship. Yet in 2009, central banks became net buyers of bullion for the first time in 21 years. A more telling pattern is the fact that indebted Western countries were selling while cash-rich countries such as China, India and Russia were buying.[xvi]

At the cusp of year 2010, the world economy was in the middle of a cycle where financial assets were falling and real assets were rising. This can be illustrated in a number of examples from the late 1970s. During that period, inflation soared and interest rates were in their high teens. Gold was hot and stocks were cold. Thereafter, equities and bonds began their greatest ever bull run. By 2000, a'new paradigm' was in place, where share prices supposedly never fell and gold was rejected as a relic. The millennium proved to be the turning point for both sets of asset classes. These cycles have been observed by the likes of Jim Rogers, author and co-founder of the Quantum fund with George Soros. In his book Hot Commodities, he identified five cycles over the course of two centuries where commodities boomed and financial markets slumped with each bullish phase averaging 17 years.

Having previously endured two decades in the shadow of the bull run, and in spite of a rally during the credit crisis, it is no surprise that gold is not widely-owned. While many investors have an indirect exposure to gold through mining shares or funds, they generally do not hold it in physical form. Islamic investors should always seek what is tangible, so holding real bullion is a Shari'a-compliant approach, especially since so much gold trading takes place by way of paper or derivatives.

The twentieth century witnessed a drift from precious metal coins to paper money and securities followed, ultimately, by electronic transactions. Unfortunately, the benefits of convenience and liquidity have been undermined by speculation and depreciation. Capital will continue to seek out the highest yield and internal rate of return with the greatest security. In times of crisis, it will naturally flow to real assets and commodities.

Precious metal commodities can provide an effective hedge against the declining purchasing power of paper currency. By way of example, one can examine the performance of the Dollar Index (a measure of the US dollar against a basket of six major currencies). Over the course of five years leading to its record low in Q2 2008, the Dollar Index declined by an annualised rate of -5%. Over the same period the gold price rose by an annualised rate of 35%. While the appreciation of gold in future may not always be of the same magnitude, the Dollar Index does show how poorly paper currency has performed relative to real assets.

Gold investing generates heated debate, between the "gold bugs" and their naysayers. "Gold bugs" frequently claim that, in times of turmoil, gold is the ultimate form of payment. However, recent history shows that gold, silver or other precious metals are not the currency of choice for basic things like paying for labour and materials, even when inflation is rife. Most people do not own it and would rather barter functional items than receive gold. However, it is a useful store of value when money is being diluted through mass production, either on a printing press or via a computer entry in the case of credit, and during exponential growth curves seen prior to a crash. As such, gold should be viewed as a long-term'ledge' rather than a short-term'safety net.' To avoid being drawn into any speculative activity with gold, Shari'a-sensitive investors should consider it to be a form of insurance. This allows one to adopt a prudent approach and to be totally dispassionate. Gold is neither a "barbarous relic" (as described by Keynes) nor a mystical metal beloved by the Celts, but rather an insurance cover.

There is much debate over the correct amount to hold in a portfolio, and like all choices of investment profile or insurance cover, it depends on an investor's personal taste and asset risk profile. The litmus test for the proportion of precious metals in an asset portfolio is whether they provide'peace of mind or loss of sleep.' Much like insurance, precious metals should be in the asset portfolio to reassure and to spread risk. Making a claim on the policy may be the least-desired outcome, but if called upon, the policy will be invaluable.

It is interesting to note that the insider selling of equities in 2009 has escalated to levels seen just before the peak of the market in 2007.[xvii] While wealthy investors will lose money on their paper assets, it is the poorest that bear the brunt of higher food and energy prices as the dollar devalues; the very people who cannot afford bullion as protection.

In an environment of currency devaluation and inflation, gold could be one of the few anchors for one's wealth. If financial and property assets are battered by inflation and interest rate rises, precious metals may offset losses once initial sell-offs occur. Much like the smelting of gold, it takes time before one can differentiate between the "pure and the dross" in financial markets. Gold can also be used to top-slice generated profits and re-invest capital into useful projects, part of which can be Shari'a-compliant private equity.

V. Innovation or Infiltration

Gold's appreciation has spurred the selling of scrap while inhibiting the purchase of new jewellery, which is seen as a luxury item. This has been the case for India in 2009, where the weak rupee added significantly to the cost of buying bullion. While its accumulation by institutions has risen significantly there is little data available on retail ownership. The scramble to buy coins and bars during the 2008 credit crisis has been matched by a great demand for paper-based gold investments in the form of Exchange Traded Funds (ETFs). While most structured products mimic actual bullion prices by way of derivatives, there are some funds, certificates and services that provide genuine ownership. Unfortunately, concerns have arisen in several cases as to whether the bullion one owns on paper is backed by real bars in a vault. There is a great deal of difference between having a call on bullion held by a third party and taking actual possession of it, including from the Shari'a perspective, with its emphasis on qabd (possession).

The custodians of some ETFs have the facility to lend out gold to earn a hidden fee, which adds another layer of counterparty risk. This has been highlighted by James Di Georgia in The Trader's Great Gold Rush.[xviii] As such, it may be advisable for investors, Shari'a-sensitive or not, to look for'allocated' gold: bars that are specifically set aside for either the individual or the fund. Storage costs may be cheap for some providers, as the full complement of bullion is not necessarily in custody at all times. A similar lack of transparency was exploited by medieval goldsmiths who issued notes in greater value than was backed by gold in their possession. This was the origin of the fractional reserve system which lies at the heart of the credit crisis and the devaluation of the US dollar. Nevertheless there are reputable ETFs, such as Gold Bullion Securities which is traded on the London Stock Exchange as an initiative of the World Gold Council. The benefit of these funds is that the dealing costs are low -in the region of half a percent -compared with coins and bullion where there could be a premium varying between 5 to 10 per cent, or even higher depending on the level of financial distress.

Many investors buy the shares of mining companies to gain access to the appreciation of these metals. For diversification purposes, it is simpler to buy a specialist investment fund that holds dozens of such companies in a well-managed portfolio. The shares of mining companies are more volatile than the underlying precious metals they discover and retrieve. Once the production costs are overcome in a mining operation then any rise in price will feed directly through to profits. This gives rise to a gearing effect whereby the price of mining shares in a gold bull market will rise more substantially than the metals they are extracting. Over the last 15 years, for every 1 per cent rise in the metal one should enjoy a 1.7 per cent rise in the shares, although the gearing effect will vary from company to company. As with any leveraged process, it will also operate on the downside. If metal prices fall, then fixed costs will eat up a larger proportion of the profits. The share price will, therefore, fall faster. As well as providing greater potential for upside performance, gold shares also show negative correlation[xix] with mainstream equities over the long-term. If the overall stock market is performing badly then it is likely that the gold shares will do well and help offset losses elsewhere. However, this inverse relationship has declined in recent years due to leverage and the close association of commodity prices with the economic cycle.

VI. Gold Storage

The major problem when buying quantities of physical gold comes with where to keep it. Without a safe or strong-room, storage at home would be unwise, especially in Britain and America. Some banks will provide what is called'safe custody' but they will of course charge an annual fee for the privilege. Some banks provide safe deposit boxes in which to safely place valuables, but these are generally too small to store anything bigger than jewellery sets or Krugerrand coins. One can also have access to communal storage of gold coins and bars of differing sizes in secure vaults. However, these are known as'unallocated' holdings and bear the same risk as a deposit at the bank. While depositor protection is also extended to precious metals in Switzerland, this is not true of every jurisdiction and, of course, the total value covered is limited. Asset security is a political as well as a physical issue. The British government used anti-terrorist legislation to freeze Icelandic assets in 2008. In 1933, the US government criminalised the ownership of bullion so that they could devalue the dollar and inflate the economy to overcome the Depression. As the nature of tax collection becomes more aggressive, every outcome should be considered.

VII. Bulls, Bears and Golden Rallies

For the more active trader, the action is often in commodities. If gold can better its 2009 highs of $1,226 then this may well be seized on by market participants that an even bigger move is in store. It is important to understand the grounds for positive sentiments. Bull markets tend to come in four distinct phases.[xx] After a long-term slump, the first stirrings of a rally go unnoticed as the asset is viewed with cynicism: only the most contrarian of thinkers is involved. The second and third phases are the main accumulation periods for wealthy individuals and professional investors. Finally, the public are drawn into the fourth climactic period where exuberance abounds. By this time, the'smart money' has made an exit, most likely being ridiculed for making such an absurd move when the bull market is so obvious.

Should the gold price begin to mimic the performance of Internet stocks in the late 1990s, then there could be a case for top-slicing (halving positions that have doubled). This allows one to take some money out of the gold market but still be involved. It also avoids the decision of liquidating an entire gold portfolio or leaving it all at risk. Gold investors can enjoy the same luxury once prices become exponential. By this stage, the fourth climactic period, the size and time of expansion is usually greater than expected. The insurance aspect will already have fulfilled its role, so selling a good percentage of the portfolio will be prudent at the maturing point of the cycle. In the meantime, the'steady switch' to other asset classes or so-called 'pound cost averaging' will mean the investor will be diversifying away from gold into other areas. This is the beauty of long-term private equity, which will be coming to fruition and maturity for public listing as precious metal prices peak.

According to South Africa's Investec Asset Management, the proportion of gold-related shares in the world's stock markets was just half a percent of the overall value in 2005. This equated to a $200 billion market capitalization compared with a total of $37 trillion of total financial assets.[xxi] In times of financial stress, this level can rise to 20 per cent plus, as seen in 1934.[xxii] As common stocks collapsed, those that derived their earnings from gold expanded, while companies concerned with consumer discretionary spending withered. A repetition of this divide would imply an incredible upside to mining stocks. Another bullish point to consider is that the ratio of the gold price to the S&P 500 peaked at 6.0 in 1980, then fell to just 0.2 in 2000 and in early 2010 now stands at 1.0.[xxiii]

It is a common theme of the commodity super cycle that financial assets perform poorly as real assets are rallying. This counters the argument of many gold bears who think that gold performs badly during deflation. This was clearly not the case in the Great Depression when mining stocks flourished. The prospect of a repeated rebalancing process has deep implications for gold shares. Another attractive aspect highlighted by Investec Asset Management, is that the gold industry is consolidating. While the top 10 gold producers control some 37 per cent of the market, this is relatively low compared with other metal producers -copper 54 per cent and platinum 98 per cent. This implies that there will be a considerable number of mine mergers, which is generally positive for share prices. Islamic investors can view rising share prices as a bonus, rather than specifically seeking take-over targets, since such speculation would involve a high degree of gharar (uncertainty). As the dollar devalues further and the political picture remains uncertain, there may be plenty of fundamental reasons to own gold. It is a key part of the preparation phase: as important as securing water supplies before a siege situation.

VIII. Reverse Alchemy: Converting Precious Metals into Economic Outcomes

Few non-Muslims realize that there was an Islamic renaissance between the 9th and 13th centuries. Contrary to claims by Joseph Schumpeter, amongst others, Islam's'House of Wisdom' acted as a repository of philosophical, mathematical and scientific knowledge. Muslim scholars preserved the accumulated wisdom and studies of the ancient world, creating libraries and research institutes at a time when books were a rarity in the rest of the world. It was not just a case of mere preservation; as Muslims were involved in translating, improving and ultimately distributing the knowledge to the wider world. However, throughout ancient Islamic history, Muslim scientists were obsessed with alchemy: the fruitless endeavour of converting base metals to gold. This theme of a short-cut to wealth still resonates through to the modern age.

With the contraction in credit in the global financial crisis, we may witness a form of reverse alchemy: turning to gold to provide liquidity. By converting precious metal into capital it can be combined with labour and materials for genuine innovation, employment and further wealth creation. Just as paper wealth can be traded-in for precious metals, so it can later be re-invested in a virtuous circle. For example, by holding gold and selling it in phases to fund private equity cash-calls, it provides the ideal form of recycling of capital, generating positive returns and helping the economy in the process. The approach purges debt and promotes stability through the reduction of leverage and expansion of equity. As such, it represents a true and sustainable version of organic growth.

If the approach above is followed, over time the proportion of gold in the portfolio will dwindle and the private equity element will increase. In the initial phase, gold acts as both a currency hedge and as a method of portfolio diversification. In times of crisis it will help to counteract the withdrawal of liquidity and declining price of paper assets. As the life-cycle continues, the value of the maturing private equity proposition will be enhanced, requiring a final injection of cash to bring the project to market.

The nurturing effect of continuous capital flow and human endeavour can pay rich rewards in the hands of good managers. As noted early in chapter 1, private equity is by its nature more risky than mainstream equity. Nevertheless, it represents a case of wealthy investors venturing where others cannot go, because of fear of financial capability. Gold offers a cocooning effect to offset private equity risks, provide liquidity and hedge against market volatility and currency devaluation.

Skillfully chosen private equity investments should be market-neutral because the technology and innovation should be attractive on its own merit, regardless of market conditions. A good example of this is UK-based Aquarius Equity's successful listing of Nanoco Technologies in March 2009, at the height of the market slump. A spin-out from Manchester University, Nanoco is now the world's leading developer and manufacturer of Quantum Dots, used in the next generation of flat-screen televisions and LED lighting. Aquarius invested 350,000 in pure private equity in 2005, when Nanoco was a start-up, and by 2010 the investee company had a market capitalisation of 158m; the perfect marriage of risk and intellectual capital. By ploughing returns into gold instead of cash, Aquarius would achieve a double benefit: enjoyment of upside private equity return and protection of the capital until it is re-invested in another promising company.

Conversely, when huge leverage is added to complex private equity transactions, it skews the original beneficial purpose of the private equity play. As noted by risk manager Richard Bookstaber, it is leverage and complexity that has created tight coupling and correlation. [xxiv] This combination has led to increasingly volatile markets in the last 20 years, countering the misplaced belief that derivatives hedge risk and cushion instability.

In many instances, Islamic private equity reserve funds could consider gold as a form of hedging. Instead of attempting to enter a questionable short position using Shari'a-compliant stocks or trading in short-term commodity murabaha vehicles or simply holding cash, gold can help diversify risk while enhancing returns. It acts as an 'event hedge' providing positive returns in periods of significant stock market declines. Most institutions do not want to hold liquidity while waiting to fund private equity cash calls, which may be many years down the pipeline. Likewise, wealthy investors often wish to 'sweat' their assets or do something constructive with stagnant cash. They may understand or instinctively feel that cash is a wasting asset because fractional banking continues to mass-produce money.

Yet, at the same time, private equity investors, be they institutions or individuals, need to have assets that are easily liquidated for cash calls. The problem with holding conventional securities is that in times of financial distress, most investments immediately lose liquidity. This is where gold comes into its own because financial turmoil generates demand for bullion, particularly when banks are unstable. This does not necessarily mean the gold price will rise or even stay stable, but it does mean that there will be willing counterparties ready to swap 'bullion for bucks.'

While the credit crisis has had devastating effects worldwide, there are some positive consequences. The contraction of credit and holding of cash could have the same effect as the Gold Standard which limited easy lending and engendered greater stewardship. Likewise, the lack of significant interest on deposits motivates depositors to consider interest-free alternatives.

Once governments stop creating money, markets can find a true equilibrium point. For a short duration, we may even see a return to Victorian-style markets, where capital growth was the exception rather than the rule; in effect, the market was a highly efficient mechanism for recycling capital back into the economy. Listed stocks acted as dividend machines such that the small, higher-risk entities generated greater yields whereas larger companies paid out smaller, but more stable, dividends. The low tax rates of the era also aided the recycling effect. In the Victorian environment, the best place for capital growth was for new issues coming to the market which underpins the role of venture capital and private equity.

In conclusion, by combining protective assets such as gold with private equity, one maintains a store of value while providing cash flow for projects, benefiting the individual investor and promoting prosperity for the population as a whole. The result may well be a transition from usury and speculation to real assets and production.

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